Collateralized debt obligations (CDOs) are a type of structured investment finance product that contain various assets and loan products. CDOs are called derivatives since they derive their value from the underlying assets within the investment. Investment banks package loans and mortgages into CDOs–similar to funds–for institutional investors to buy. However, CDOs can contain many types of assets or investments, including mortgage loans.

Key Takeaways

  • Collateralized debt obligations (CDOs) are structured investment products that contain various assets and loan products.
  • If the loans within a CDO are mortgage loans, the product is often referred to as a mortgage-backed security (MBS).
  • The credit products are repackaged and grouped into tranches based on the credit risk appetite for the investors buying the CDO.

Understanding CDOs and the Mortgage Market

The goal of creating CDOs is to use the debt repayments–that would typically be made to the banks–as collateral for the investment. In other words, the promised repayments of the loans and bonds give the CDOs their value.

As a result, CDOs are cash flow-generating assets for investors. Although CDOs are typically associated with the mortgage market, they can include various types of investments and debt—such as mortgages, corporate bonds, lines of credit, auto loans, credit card payments. All of these credit products are repackaged and grouped into tranches based on the credit risk appetite for the investors buying the CDO.

If the loans within a CDO are mortgage loans, the product is often referred to as a mortgage-backed security (MBS). If the mortgage loans in the CDO were made to borrowers with less than stellar credit or no credit history, they're called subprime mortgages. Although the term "subprime" often pertains to mortgages, other credit products have subprime categories, including auto loans, credit lines and credit card receivables that are higher risk.

CDO Credit Structure

Initially, all the cash flows from a CDO's collection of assets are pooled together. This pool of payments is separated into rated tranches. Each tranche also has a perceived (or stated) debt rating to it. Credit and debt products are assigned credit ratings, which measures their likelihood of default. Default occurs when a party can't pay back interest and principal amounts from a loan or financial instrument.

Standard & Poor's (S&P) is one of the companies that provides investors with independent credit ratings as well as being the provider of the S&P 500 Index. The top tier rating is usually 'AAA' rated senior tranche. The middle tranches are generally referred to as mezzanine tranches and generally carry 'AA' to 'BB' ratings, and the lowest junk or unrated tranches are called the equity tranches. Each specific rating determines how much principal and interest each tranche receives.

The 'AAA'-rated senior tranche is generally the first to absorb cash flows and the last to absorb mortgage defaults or missed payments. As such, it has the most predictable cash flow and is usually deemed to carry the lowest risk. On the other hand, the lowest-rated tranches usually only receive principal and interest payments after all other tranches are paid. Furthermore, they are also first in line to absorb defaults and late payments. Depending on how spread out the entire CDO structure is and depending on the loan composition, the equity tranche can generally become the "toxic waste" portion of the issue.

Investing in CDOs

Typically, retail investors can't buy a CDO directly. Instead, they're purchased by insurance companies, banks, pension funds, investment managers, investment banks, and hedge funds. These institutions look to outperform the interest paid from bonds, such as Treasury yields. However, these companies assume an added level of risk with buying CDOs that accompanies the additional rate of return.

Of course, the added risk levels that CDOs exhibit might adequately be compensated by the higher returns in a stable economic environment. However, if the economy falls into a recession, the risk of default on the mortgage loans that act as collateral for CDOs can rise dramatically. The result can lead to losses for CDO investors.

Asset Composition Complications

To make matters a bit more complicated, CDOs can be made up of a collection of prime loans, near prime loans (called Alt.-A loans), risky subprime loans, or some combination of the above. These are terms that usually pertain to the mortgage structures.

If a buyer of a CDO believes the underlying credit risk of the loans is investment grade, the firm would likely accept a lower yield that's only slightly higher yield than a U.S. Treasury. Debt instruments with a low risk of default typically pay a lower interest rate while riskier debts command a higher rate by investors to compensate for the added risk of default.

However, the issuer of the CDO can come under pressure if it turns out that the underlying mortgages were much riskier than the yield would dictate. Whether the underlying CDO loans are rated properly is one of the hidden risks in more complicated CDO structures. In other words, the risk of investing in CDOs can increase if the loans made to the borrowers weren't as prime as the lenders had initially believed.

Other Complications

Other than asset composition, other factors can cause CDOs to be more complicated. For starters, some structures use leverage and credit derivatives that can trick even the senior tranche out of being deemed safe. These structures can become synthetic CDOs that are backed merely by derivatives and credit default swaps made between lenders and in the derivative markets. A credit default swap is essentially used by buyers of CDOs as insurance against non-payment. The buyer shifts the risk of the CDO's non-payment by buying the CDS through an insurance company or other CDS seller in exchange for a fee.

Many CDOs get structured such that the underlying collateral is cash flows from other CDOs, and these become leveraged structures. This increases the level of risk because the analysis of the underlying collateral (the loans) may not yield anything other than basic information found in the prospectus. Care must be taken regarding how these CDOs are structured because if enough debt defaults or debts are prepaid too quickly, the payment structure on the prospective cash flows will not hold and some of the tranche holders will not receive their designated cash flows. Adding leverage to the equation will magnify any and all effects if an incorrect assumption is made.

The simplest CDO is a 'single structure CDO,' which poses less risk since it's usually based solely on one group of underlying loans. It makes the analysis straightforward because it is easier to determine the expected cash flows and the likelihood of defaults.

Special Considerations

The CDO market exists since there's a market of investors who are willing to buy tranches–or cash flows–in what they believe will yield a higher return to their fixed income portfolios with the same implied maturity schedule.

Unfortunately, there can be a huge discrepancy between perceived risks and actual risks in investing. Although CDO buyers may believe that the product will perform as expected, credit defaults can happen, and there is often very little recourse. It may become difficult to unwind a position to stop the losses if the credit markets are deteriorating and loan losses are increasing. In such an environment, the market can dry up, meaning there could be no liquidity. The result can lead to investors trying to sell their CDO positions, only to find there are no buyers.

Will CDOs Ever Disappear?

Regardless of what occurs in the economy, CDOs are likely to exist in some form, because the alternative can be problematic. If loans cannot be carved up into tranches, the end result will be tighter credit markets with higher borrowing rates.

As long as there is a pool of borrowers and lenders out there, you will find financial institutions that are willing to take risk on parts of the cash flows. Each new decade is likely to bring out new structured products, with new challenges for investors and the markets.